Market Suffers 400-Point Decline, the Year's
Worst

T he stock market just finished its worst week since early January, with the Dow Jones Industrial Average falling 400 points, or 4.3%, to 8937, and the Standard & Poor's 500 suffering a loss of nearly 4%. Small stocks, as measured by the Russell 2000, fared even worse, sliding more than 5%.

The Dow's decline was the biggest in point terms this year, and marked the largest weekly percentage loss since the five days ended January 9, when the index lost 384 points, or 4.8%. The latest setback ended a month-long rally that had lifted the Industrials by over 700 points to a record 9337 on July 17.

Though the Dow actually climbed four points in Friday's trading, it wasn't enough to erase the sense of unease that had pervaded Wall Street in the previous four sessions.

Investors got thrown for a loop because they had been expecting a string of upbeat profit news in the heaviest week of earnings reports of the quarter. What they got were a series of disappointments, or warnings about earnings in the second half, from such giants as
Boeing
,
Walt Disney
,
Hewlett-Packard
,
DuPont
,
Computer Associates
,
Banc One
and
Merck
.

"People were feeling complacent because they felt all the bad profit news was out of the way," observes Laszlo Birinyi, president of Birinyi Associates. "But, lo and behold, we got some negative surprises."

If that weren't enough to depress the market's spirits, Federal Reserve Chairman Alan Greenspan told Congress that no cuts in interest rates are likely soon, and that the Asian economic crisis "shows no signs of stabilization." He also said that current Wall Street expectations of long-term growth in corporate profits of 13% are "unrealistic."

Perhaps the stability that took hold on Friday will continue into next week. Stocks have shown remarkable resilience this year, regularly bouncing back from periodic setbacks. Birinyi notes that money, on balance, continues to flow into the Dow stocks, a bullish sign.

Market breadth, or the ratio of winning stocks to losers, remains poor, however. Declining stocks on the New York Stock Exchange topped advancers by a margin of over three-to-one during Thursday's rout, when the Dow fell 195 points. And even on Friday, when the index managed a tiny gain, losers beat winners by a margin of more than three-to-two.

As of Friday, about two-thirds of the companies in the S&P 500 had reported earnings, posting an aggregate gain of 2.7%, according to I/B/E/S International. Joe Abbott, I/B/E/S' chief investment strategist, says that if current profit forecasts are met for the remaining companies in the S&P, the quarterly gain in operating profits for the entire index will be about 1.7%, similar to the lackluster 1.3% gain in the first quarter. The second-quarter numbers do look stronger if such outright profit drops for companies like
Intel
,
Compaq
, and
General Motors
are excluded.

T he week's losses were broad and deep, cutting across more than 90% of the S&P industry groups. Economically sensitive stocks, as well as many energy and oil-service issues, were especially hard-hit. Among the few winning groups were the traditionally defensive Baby Bells, as well as tobacco companies and the auto makers.

Oil-service issues got clobbered, falling an average of 14%, bringing their losses since early May to 40%. All the major stocks, including
Schlumberger
,
Baker Hughes
and
Halliburton
, hit new 52-week lows Friday. Crude-oil prices held around $14 a barrel last week, but earnings estimates are being cut because of reduced drilling activity.

Admirers of cyclical stocks are frustrated because they feel the market is discounting disaster for many of their favorites. Take
Deere
, the world's leading maker of farm equipment, which fell 6 1/4 to 42 1/2 last week, after hitting a new 52-week low of 41 3/4 . Deere recently backed Street earnings estimates of around $4.50 a share for 1998 and said it looks for 10% profit growth in 1999. But investors fear the weakening global farm economy will pinch Deere and its rivals. That said, Deere now trades at less than 10 times projected 1998 profits.

B oeing was the Dow's biggest percentage loser on the week. It slid by 9 11/16 points, or 19.4%, to 40 5/16, after stunning Wall Street with a weak profit outlook. Many value-oriented investors had piled into the aircraft maker in recent weeks, viewing it as one of the most attractive big stocks. But some of those investors headed for the exits after Boeing indicated that its production problems and competitive position with rival Airbus will result in greater profit woes than most investors and analysts had anticipated.

Analysts had expected Boeing to earn $1.60 in 1998 and as much as $3.70 a share in 1999. But the company projected profits of just $1 for this year and only $2 for 1999. This suggests that Boeing may not cash in on the boom in commercial aircraft orders in recent years. Boeing's stock could be close to a bottom, however. The company has a cash-rich balance sheet, a relatively modest market value of $40 billion and its stock trades no higher than it did in late 1995. This could be an opportunity to buy one of the world's leading manufacturers when it's thoroughly out of favor on Wall Street.

M erck also disappointed the Street, reporting second-quarter profits of $1.07, a penny below estimates, and telling analysts that it's comfortable with a 1998 profit estimate at the lower end of the current range of $4.27-$4.38 per share. Merck dropped 12 1/4, to 125 3/4 .

Merck's warning reinforced investor concerns about the quality of its drug pipeline and the loss of patents on several key products in 2000 and 2001. Yet Neil Sweig, drug analyst at Southeast Research Partners, called the selloff a "golden buying opportunity." Merck, he says, can earn $5 in 1999, and he's upbeat on the company's new drug for arthritis, which should hit the market next year. Trading at 25 times projected 1999 profits, Merck, the traditional industry leader, now has one of the lowest multiples in the drug group.
AT&T
rose 7/8, to 59 15/16. Late Friday, CNBC reported that the company and
British Telecom
will form an international alliance.

S mall hasn't been beautiful this year. With last week's loss, the Russell 2000 is now up less than 1% in 1998. Economically sensitive stocks, as measured by the Morgan Stanley cyclical index, have struggled as well, rising just 3% in 1998, while consumer issues are up an average of 17%.

A irline stocks have hit an air pocket in the past 10 days despite solid second-quarter profit reports, low oil prices and strong domestic traffic.

The selloff appears to reflect investors' fear of a slowdown in the American economy, which could be reinforced by second-quarter gross domestic product figures slated for release this week. GDP might have declined at a 1% annualized rate. Moreover, there are concerns about weak airline traffic on Asian and Latin American routes. In addition, cyclical stocks have been weak across the board lately, and the airlines historically have been among the most cyclical industry groups.

But one Street analyst calls the move an "overreaction" and says the stocks look very attractive, trading at low multiples of projected 1998 and 1999 profits.

"Airline cycles usually don't end periods of falling rates and rising earnings," says Kevin Murphy, airline analyst at Morgan Stanley.
AMR
, parent of American Airlines, fell 2 3/8 to 71 1/8 on the week and dropped over 18 points from its record on July 14.
Delta Air Lines
was off 3 to 129 5/8, and
UAL
, parent of United Airlines, dropped 7 1/4 to 78.

The airlines now sport the lowest multiples of any major industry group, and the combined market value of all the major carriers is less than that of
Dell Computer
. AMR and Delta trade at less than 10 times projected 1998 profits, and Murphy sees higher profits for both companies in 1999.

AMR and Delta continue to aggressively buy back stock and both sit on valuable assets. AMR's interest in
Sabre Group Holdings
, the reservation system, is worth about $25 per AMR share. This means that buyers of AMR are effectively getting the airline business for $46 a share, or less than eight times projected 1998 profits. Murphy says AMR's interest in Sabre likely will be spun off to AMR holders within two years.

Delta's ownership in a competing reservation system and various commuter airlines is worth an estimated $15 per Delta share. UAL, meanwhile, trades at under eight times profits because of its Asian exposure. Murphy's top pick is AMR, but he's also bullish on Delta and UAL.

With the recent drop in the airlines and the poor performance of the railroads this year, the Dow Jones Transportation Index is up just 2.5% in 1998.

R alston Purina is known as the "Kremlin" on Wall Street because the company doesn't talk much to the investment community.

So when Ralston, a maker of pet food as well as Energizer and Eveready batteries, reported earnings for its third quarter last week that fell four cents short of expectations, its stock swooned, going as low as 30 before ending the week at 32 3/16, down 4 11/16.

But the selloff could provide an opportunity because the earnings miss was more related to increased marketing spending ahead of the launch of a new battery rather than anything fundamental. The company was hurt by slower Asian battery sales, but had strong results in pet foods.

"Ralston has two great businesses," says Kevin Grant, an analyst at Harris Associates, manager of the Oakmark funds. "Because the company doesn't smooth out its earnings, you really have to average the past three or four quarters."

Ralston's operating profits of 23 cents in the latest quarter fell short of the First Call consensus of 27 cents and were up a penny from the year-earlier level. But Ralston profits for the March period beat Street estimates.

Ralston is the leader in the U.S. pet-food market, with a market share of more than 25%, and it dominates the dry-food category with its well-known Purina dog chow and other brands. Ralston's Eveready and Energizer brands are a solid No. 2 to
Gillette's
Duracell in the global battery market. Pet food accounts for about 60% of its profits; batteries, 40%. Ralston also has valuable stakes in
Interstate Bakeries
and DuPont worth over $7 a share.

Once a conglomerate, Ralston has narrowed its focus in the past few years, selling its soy protein business to DuPont and its Continental Bakeries division to Interstate.

The stock doesn't appear cheap at 27 times projected fiscal 1998 profits of $1.22, but that doesn't reflect Ralston's equity stakes in DuPont and Interstate Bakeries. The company's fiscal year ends in September. Profits are seen rising about 11% next year to $1.38 a share. Adjust the estimated 1999 net for Ralston's interest in DuPont and Interstate Bakeries, and the company's multiple is close to 20, below those of such consumer products firms as
Bestfoods
,
Hershey
and
Heinz
.

Moreover, Ralston is showing stronger unit growth than virtually all other consumer-products companies. It is benefiting from growing market share in the pet-food business and from favorable canine demographics. Americans are buying more dogs -- and, importantly, bigger ones, which eat more.

Grant says there's a good chance that Ralston will split its battery and pet-food businesses, a move that would be welcomed on Wall Street, where pure plays are favored. What's the upside? Bulls say the stock could be worth at least $40.

S plitting a stock is the financial equivalent of cutting a pizza into eight slices rather than four. It doesn't have any real impact on a company.

Yet investors love splits because they feel richer when they have two pieces of paper rather than one. And split-based investing strategies have never been hotter, driven by the runup in companies like Dell Computer,
America Online
,
Amazon.com
,
Lucent Technologies
and
Warner-Lambert
, which all have split their shares this year.

There are Internet services that handicap split possibilities among hot stocks like Lucent, and even paging companies that can alert you when a split is announced. Basing an investment discipline around splits sound wacky, but it turns out to be a pretty good approach to buying stocks.

Merrill Lynch looked at all the splits among companies in the S&P 500 since 1986 and found that the split shares, on average, beat the index's performance in the 12 months following the division.

The Merrill performance measurements were keyed to the actual day of the split. Companies splitting their shares topped the S&P by about 5% on average in the following 12 months. Beating the S&P is no small feat considering that more than 80% of all money managers fail to do so.

"A split strategy is just another way to buy stocks that have performed well and where managements are confident about their outlooks," says Steve Kim, a quantitative analyst at Merrill Lynch.

Many investors instinctively look to buy depressed stocks, but the record shows that purchasing winners is a far better tactic. If history is any guide, the new highs list from last week offers better prospects than the new lows list. Among the few new highs Friday on the Big Board were
Anheuser-Busch
and
Chrysler
, now a proxy for Daimler-Benz, given their coming merger.

Kim cautions that the variability of returns among companies that split their stocks is high. But he says the split group beat the S&P in each of the 11 years of the study. The 45 companies that split their stocks from January to mid-July 1997 bested the index by 4.6% on average in the ensuing year.

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